Orders, execution and leverage

Lesson 6 of 6

Margin calls

As we've discussed, to open a leveraged trade you need only deposit a fraction of its full value, but your losses can exceed this amount. This means that, if a position moves against you, your provider may ask you to provide additional funds to keep your trade running.

These payments are properly known as 'variation margin', although people usually just refer to them as 'margin'. A request for variation margin is called a margin call.

Example

Say you buy 8000 shares at $2.20 using leverage. The value of your position is therefore $17,600. The provider asks for an initial margin payment of 5%, which is $880.
The share price then drops by $0.01 to $2.19, reducing the value of your position to $17,520. The margin requirement falls to 5% x $17,520 = $876 as a result.
However, although the initial margin requirement has reduced, you now have a running loss of $0.01 x 8000 = $80.00 to add to this, bringing the total required to keep your position open to $956. Unless you're already holding sufficient funds in your account to cover this, your provider will ask you to make a margin payment. If you don't do so promptly, they may scale back or even close your position completely.

Dividend payments on short positions and funding costs are other factors that may sometimes put your account into deficit, requiring you to deposit more money. So it's wise to remember that the initial cost of opening a position isn't the end of the story – you may need to have more funds available to top up your account as you go.

Deciding whether to use leverage

We've seen that trading with leverage gives you comparatively greater profits – but also relatively larger losses. So does that make it riskier than conventional trading?

From one perspective, yes. If you commit yourself to a leveraged trade based on the affordability of the initial margin, rather than your capacity to withstand the potential losses, you're undoubtedly playing with fire.

However, as long as you think of every position in terms of its full value and downside potential, the risk is no greater than it would be when trading directly. Your eventual profit or loss is the same – it's only the outlay to produce it that differs.

There are also a number of steps you can take to manage the risks of trading. We explain these in the 'Planning and risk management' course.

So, provided you understand how leveraged trading works, it can be a very useful tool: there's no need to tie up a large amount of your trading capital on one trade, and you can deal on expensive assets at a fraction of the cost. Used sensibly, leverage can make trading easier and more convenient.

Ways to trade with leverage

A wide range of leveraged trading products are available, covering almost every conceivable market, and many providers offer at least some degree of leverage on trades.

Most leveraged trading is done through derivative products: financial instruments that derive their value from an underlying asset. With a derivative contract you never own the underlying asset directly, but you have a financial interest in its performance.

Here are the main ways you can choose to trade with leverage:

  • Contracts for difference (CFDs)
    A CFD is an agreement to exchange the difference in value of a particular asset from the time at which the position is opened to the time at which it is closed.
  • Forex trading
    You can speculate on the future value of one currency compared to another via a forex broker.
  • Futures
    A futures contract is an agreement to buy or sell an asset at some time in the future for a particular, specified price.
  • Digital 100s
    Digital 100s are yes/no deals that enable you to speculate on the performance of a particular financial market over a designated time, with only two possible outcomes.
  • Options
    Options are contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a fixed price on or before a certain date.

Lesson summary

  • If a leveraged position moves against you, you may get a margin call from your provider asking you to top up your account
  • Leveraged trading can be regarded as riskier than traditional trading, although profits and losses are the same in both cases and only the initial outlay differs
  • Leveraged trading is mainly carried out using derivative products
Lesson complete